One of the most contentious discussion topics in Washington these days concerns the role of government in our economy. “Businesses are being choked to death and driven away from this country by over-regulation and unreasonable taxation.” “Unbridled multinational corporations are destroying the lives and liberties of millions of Americans who cannot afford food, shelter, transportation, and healthcare.” What tasks are properly tackled by the public sector?
First, a bit of history mingled with a few statistics is useful. During the first 100 years of our nation’s existence, government based employment rose from close to nil to approximately four percent of the workforce. The 19th century, with its modest government sector, was thus characterized by an economic policy of “laissez faire” or “let them do” as they wish.
Today, the U.S. local, state, and federal governments employ close to 15 percent of the working population, which is just below the median level of the Organization for Economic Cooperation and Development group of nations. Norway and the rest of Scandinavia stand at the top with between 23 and 30 percent of the labor force employed in the public sectors. At the bottom of the group are Mexico, Chile, Greece, and Japan, with less than 10 percent.
What changed between the 19th century and today? Why has the world seemingly abandoned the libertarian doctrine of laissez faire? How did the democracies of the world come to choose a significant level of public involvement in our capitalist economies? One simple word answers these questions: experience.
Up until the crash of 1929 and the ensuing Great Depression, enterprise in the U.S. and western Europe was assumed to operate most efficiently when left on its own. Adam Smith, in his “Wealth of Nations,” laid the theoretical framework for a hands-off economic policy. When the crash came, eventually sidelining one fourth of our entire labor force, people justifiably began to question the validity of the laissez faire religion.
According to the doctrine, free markets were supposed to generate the most efficient allocation of resources throughout an economy. Markets would ensure that the right goods and services would be produced by the right number of people in the right quantities for the right prices. Could there be any greater refutation of the hypothesis of market efficiency than a 25 percent unemployment rate caused by consenting adults operating within the framework of free markets?
To be sure, there were signs of so-called “market failures” prior to the most colossal of all failures, namely, the Great Depression.
For many decades prior to 1929 people had lost their life’s savings through bank failures. Farmers had frequently found that low prices due to bumper crops brought them too little to make ends meet. The industrial revolution had created an elite class of “robber barons” which mirrored the teaming masses of poor. Somehow the promise of efficient markets failed to deliver.
Each educational discipline has its own tools and techniques for analysis. When economists observe the Great Depression with its origins of the Roaring Twenties and its end at the outset of World War II, we see a great social experiment in macroeconomic theory. We see the crash and depression as a market failure caused by a sudden and long-lasting drop in spending.
Most historians I have met have told me that WWII ended the Depression. Economists qualify this slightly.
To be clear, WWII was an economic disaster on a grand scale. We killed off a portion of our labor supply. We destroyed large portions of our capital equipment. For years, we produced durable goods, which we then blew up. Yet, WWII was one of the great economic experiments which has given us invaluable insight into the workings of an economy.
It was not WWII that ended the Great Depression. It was the large-scale debt-financed government spending which put people back to work. The fact the spending was part of a war effort illustrates just how far off the track government spending can be and still be the cure for a recession.
Put another way, if government spending on something as economically crippling as a war can bring an end to a depression, then how much more beneficial could increased spending on infrastructure or education or any number of other things be?
It is this historical backdrop which moved men and women to consider an expanded role for government within the framework of a market economy. Market failures occur. Governments can help.
If the 19th century, leading up to the Great Depression, helped to highlight the problems with unregulated markets, the 20th century hosted another economic experiment of monumental significance. Many decades of central economic planning within Cuba, North Korea, the Soviet Union, and numerous other nations failed to deliver efficiency in production, stability, or equity. These and other public production experiments brought into focus what economists call “government failures.”
At this point in the economic history of mankind, we have a reasonable amount of data and experience regarding what types of failures are most common to markets and governments, and what type of strengths come from each. During our next several weeks, we will examine, from an economic perspective, these strengths and weaknesses. We will then resume our miniseries on the history of economic thought.
Before closing this week’s humble musings, we should point out two important concepts which will be omnipresent in the future columns. First, economics is often split into two broad branches: “positive” economics and “normative” economics.
Positive economics deals with what is. Normative is concerned with what should be. For example, positive economics can tell us that if we raise the tax on a gallon of gasoline by 50 cents, consumption will drop by such and such, and x portion of the new tax will be absorbed by producers.
Normative economics might venture into the area of whether this is good for society. Lower fuel consumption reduces pollution and greenhouse gases. Yet higher fuel costs hurt the poor. These are normative topics. When we deal with public sector economics, both of these aspects come together.
Finally, Richard Musgrave, perhaps the 20th century’s greatest public sector economist, created a very nice framework in which to think about government involvement in the economy. He taught that there are three branches of economic government: the stabilization branch, the allocation branch, and the distribution branch.
The stabilization branch is involved with maintaining steady prices and employment. The allocation branch directs spending toward goods and services which would otherwise be less efficiently produced, or perhaps not produced at all by the market sector. Finally, the distribution sector is concerned with issues of equity and fairness.
While Musgrave’s model is helpful in understanding the three main areas in which the public sector impacts our economy, it will become clear, if it is not already obvious, that most policy choices involve all three aspects of stabilization, allocation, and distribution. This makes policy contentious in a nation as politically divided as ours.
Next week we will come together to discuss the conditions necessary for efficient markets and the nature of market failures.
(Marcus Hutchins, MA, M. Phil, Economics, Columbia University, NYC, is a former economist, treasury bond arbitrage trader and hedge fund manager. He retired to Southport in 1997 where he resides with his wife Andrea and his youngest daughter Abbey. He welcomes feedback at coastaleconomist@me.com.)
